Investment vehicles take many forms, and can be designed to give investors varying levels of potential returns and exposure to loss. The investment vehicles referred to as “structured products” are designed to provide simplified means to achieve complicated risk/return objectives by modifying the payoff structure of an underlying reference asset or index. Structured products are most often issued by investment banks, which accept funds from an investor or investors and provide in return, for example, a note, which promises to pay an amount on some future date certain based on the performance of a specified asset or index. Structured products can also take the form of certificates of deposit or other instruments. There are, however, inherent limitations for structured products that this invention addresses and overcomes. Those limitations include issuer credit risk, the inability to qualify for listing and trading on US exchanges, and difficulties with valuation and transparency of pricing. As a consequence, demand in the US for these products is limited. The value of structured product investments measured as a percentage of GDP is much smaller in the US than in Europe and Japan, which have, among other things, lower regulatory barriers for broad offerings of structured products.
When the structured product is in the form of a note, the amount paid on the note depends on its payoff structure. For example, the payoff structure of many structured notes is designed with a view to limiting the risk of loss of principal invested in the note, the performance of which is tied to the performance of an underlying asset, while still benefitting from gains in the underlying asset. This type of note is typically referred to as a principal protected note. FIG. 1 shows the payoff structure for a simple example of a principal protected note. In this example, the horizontal axis represents the return on a reference security (Rs) and the vertical axis represents the return on the structured note (Rn). When the return on the underlying security (Rs) is negative, i.e., when the security has declined in value, the return on the note is flat at zero, indicating no loss of principal invested. When the return on the underlying security is positive, i.e., when the security has increased in value, the return on the note is likewise positive, although less positive than the return on the underlying security. The returns are generated through a combination of investments.
Structured products provide simple vehicles for replicating more complex transactions. For example, the principal protected structured product shown in FIG. 1 replicates the combination of investments shown in FIG. 2. In this example, an investor buys the structured note from a bank for $1000 at time t0 with a maturity date at some later time t1. The bank-issued note's payoff structure replicates the combination of investing a portion 101 of the principal amount in a low-risk investment such as a bond with a maturity date at t1, and the remainder 102 in a call option on the underlying security with a strike price equal to the value of the security at time t0 and with an expiration date of t1. The amount invested in the bond 101 is determined so that, given the time to maturity and the rate of return on the bond, the value of the bond at maturity (t1) is the same as the principal amount invested, $1000, thus preserving the investor's full investment regardless of whether the underlying security has advanced 103 or declined 104. If at time t1 the security has advanced 103, the call option will have a value related to the amount of appreciation in the underlying security, thus allowing the investor to participate in the appreciation in the underlying security. If the security declined 104, however, the call option would expire worthless, but the investor's initial investment still would be protected by the value of the bond at maturity.
At the same time that structured products provide simplified means to achieve complicated risk/return objectives, they have certain inherent limitations that this invention addresses and overcomes.
First, a major drawback of structured products in the form of notes is issuer credit risk. Structured notes typically are unsecured debt of the issuer, usually an investment bank, and as such, the ultimate payoff of the note—regardless of the performance of the underlying asset—depends on the issuer's ability to meet its payment obligations. These notes also are not insured by the FDIC nor are they collateralized by other means. As a result, there remains the possibility of loss of principal for reasons unconnected to the performance of the underlying asset, making the notes less attractive as an investment opportunity.
In addition, investors—in particular retail investors—often do not fully appreciate that issuer credit is a factor in the likelihood of return of principal and in fact sometimes incorrectly assume that their initial investment is fully guaranteed. When Lehman Brothers declared bankruptcy, holders of “Principal Protected Notes” issued by Lehman Brothers found that their principal investment was not, in fact, protected from Lehman Brothers' default and lost most of their investments in the notes. As a consequence, the volume of structured note issuances has declined significantly following the Lehman bankruptcy as investors have become more aware of, and concerned with, issuer credit risk. This concern has resulted in a particular need in the art for structured products that minimize credit risk.
Some issuers have addressed credit concerns by issuing structured certificates of deposit (“structured CDs”), which are guaranteed by the Federal Deposit Insurance Corporation (FDIC). There are, however, several limitations to structured CDs. First, the amount of investment covered by the FDIC guarantee is capped, and structured CD investments are aggregated with other insured deposits at the same institution in applying that cap. Additionally, there is some uncertainty as to whether or not the FDIC guarantee for structured CDs will continue to be available indefinitely. Further, structured CDs are not securities and are therefore not eligible to be listed and traded on a national securities exchange (see further discussion below), and so there are limited mechanisms for investors to get out of their investments, at a loss or otherwise, before the investment reaches maturity.
A second disadvantage of structured products is that most do not meet the initial distribution requirements necessary for exchange listing. These requirements include minimum distribution thresholds which serve as a indicators of sufficient supply and ownership base to provide for reasonably liquid secondary market trading on the exchange. For example, a non-redeemable structured note must have been sold to at least 400 public holders and have issued at least 1,000,000 shares worth at least $4 million. The inability of many structured products to meet the listing requirements forces such products to trade in the over-the-counter markets and preclude exchange listing.
Exchange listing provides many benefits to investors. One of the most important benefits of exchange listing is that it gives investors a dependable and transparent way to divest themselves of their investment prior to maturity by selling to another investor. This ability to buy and sell throughout the trading day typically is referred to as “liquidity,” and exchange-listed products generally have liquidity. Structured products that are not exchange-listed are more likely to have liquidity limitations.
Further, since exchanges provide a transparent venue for buyers and sellers to indicate prices at which they are willing to buy or sell a security and facilitate those transactions when buyer and seller agree on price, and since information about these prices is publicly disseminated, exchange listing is an important means for discovering the fair market price of any financial product, including listed structured products. In other words, exchange listing helps ensure that investors can sell their investment at a fair price if they do not wish to hold their investment to maturity. Finally, investors benefit from exchange listing because of the heightened regulation that exists for listed financial products.
A third disadvantage to currently available structured products, and to structured notes in particular, is that they typically do not allow for creation of additional notes to accommodate demand. The inability to issue additional products in response to demand may lead to material mispricing versus the fair value of the underlying structured payout terms—that is, heightened demand that is not met by increased availability will result in a higher price that does not accurately reflect the prospective value of the underlying payout.
Other patents have attempted to address certain aspects of the invention, but none addresses all of the aspects of the invention. For example, Bodurtha et al. (U.S. Pat. No. 7,433,839) covers some of the issues associated with the difficulty of selling futures to retail investors, but does not address in any manner the efficient delivery of risk return profiles similar to structured products. Frankel et al. (U.S. Pat. Appl. Pub. No. 2006/0036533) also address the ability to deliver futures to retail investors, although somewhat differently than Bodurtha, by placing such futures in a trust for distribution within a security structure. However, like Bodurtha, Frankel fails to address in any manner the efficient delivery of risk return profiles similar to structured products. Finally, Kao et al. (U.S. Pat. No. 7,475,033) addresses the concept of creating a principal protected structured payout in a security, in this case via a trust holding a combination of over-the-counter (OTC) options and treasury securities. In contrast to futures contracts, these OTC option contracts represent bilateral arrangements between two parties without a central clearing house. However, Koo fails to address to provide for payout structures other than principal protection and does not specifically address credit risk concerns, pricing transparency and the complex valuation associated with current structured products
There is thus a need in the financial industry to provide a financial instrument that: (1) efficiently provides desirable risk/return profiles similar to those provided by existing structured products, (2) does not carry issuer credit risk, (3) can be listed and traded on an exchange, (4) has transparent pricing or simple valuation, and/or (5) can readily be sold to retail investors.